Derek Gates, On Building an Energy Index

Derek Gates is the founder of Sustainable Wealth Management in Calgary, Canada.

There are about 30 ETFs that cover the energy sector, so an investor might think that the space is exhausted. But about eight years ago our company began to notice that the majority of those ETFs were weighted by market capitalization. As a result they were dominated by just a few giant oil companies, like Exxon MobileChevron and ConocoPhillips.

If you’re a financial adviser or manager, you could think that by investing in a few energy ETFs you’re doing a good job of diversifying assets across that sector, when in fact in most cases, 30% to 50% of those assets are going to just a few, large U.S. companies.

At our firm we decided to develop a different kind of energy index, which focused on a wider swath of companies from the oil distributors and refining companies to the pipeline companies and companies that make the drilling equipment—the whole chain of companies that are involved in the process of harvesting oil.

We also wanted to make the index equally weighted, so that a few companies don’t dominate the index. This helps diversify the index both in terms of the types of companies and their geographic locations.

I used to be a wealth adviser for high-net-worth clients, and one of the things we worried about was event risk. We didn’t want to wake up and find that our client’s real estate assets had been confiscated by an Angolan dictator. And yet many of the U.S. companies that are heavily weighted in most ETFs harvest oil from politically unstable areas in the Middle East or South America.

It’s wise to include companies that operate in geographically diverse, and stable locations. For example, one of our energy indexes, the Sustainable North American Oil Sands Index, focuses on companies that are harvesting the oil sands region in Alberta, Canada, where there are at least 1.7 trillion barrels of oil are waiting to be extracted. The index also invests in major international companies, many of them Chinese, which are prospective buyers of the smaller Canadian outfits.

The lesson for advisers is that not all indexes or ETFs are made the same way. It’s important to take a look inside before you invest in one.

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